Sunday, May 9, 2010

A Prediction from Henry Hazlitt, Meaning for Us

Recently I was searching for a book on telescopes in my library when I came upon a book that I didn’t recall owning. It was obvious why I owned it, when I bought it, and from whom. I just didn’t remember it. I probably haven’t read it. I will. The book is The Inflation Crisis, and How to Resolve It, Second Edition (1983), by Henry Hazlitt. I read the Preface to the Second Edition and was shocked. It was written in March,1983 and suggested a future far different than what we lived through. I have copied all but the first couple paragraphs:

I do think it necessary, however, to call attention here to a development of the last two or three years that was not analyzed in my earlier book because it had not occurred up to 1978 – at least not to such a dramatic extent. This has been the sudden and sharp rise in real interest rates to a level that brought about a deep recession in business and consequent mass unemployment.

Economists have long pointed out, of course, that in an inflation that has gone on for some time, and is expected to continue, nominal interest rates rise. Lenders want not only a normal rate of return, but a “price premium” to compensate them for the expected fall in the purchasing power of their dollars when they get them back. I discussed this in my 1978 book. (Ch. 17, pp. 121 et seq.)

But the rise in interest rates in the summer of 1982 was much grater than the general expectation of the future inflation rate prevailing at that time would have brought. It was a “real” and not merely “nominal” rise in interest. It made private borrowing almost prohibitive.

This was a result of a combination of two factors. The first was a sharp increase in the size of the deficit. The second was the refusal of the Federal Reserve System to monetize the debt to any but a minor extent.

The deficit for the fiscal year 1982, which ended Sept. 30 of that calendar year, was $110.7 billion (compared with an average deficit in the tree preceding years of $48 billion). If the Federal Reserve had bought the government’s securities in the open market to an equivalent amount – a frequent practice in the past – this would have led immediately to an accelerated inflation. But it refrained. The result was that the government’s enormous borrowings in the open market sent interest rates soaring, and “crowded out” part of the private borrowing that would otherwise have taken place for business expansion or even for continuance of normal production.

As long as deficits of the dimensions of fiscal 1982 continue there is a prospect of either prohibitive interest rates or galloping inflation in the immediate future, depending on how the deficits are financed. We could easily have a combination of both.

Yet this is precisely the policy that is now officially planned. The President’s budget message of Jan. 31, 1983 projected a deficit of $188.8 billion for the fiscal year 1984. And even on the assumption that his proposed cutbacks and freezes in spending are adopted, his budget message forecasts deficits of $194 billion in fiscal 1985, $148 billion in 1986, $142 billion in 1987, and $117 billion in 1988. When we consider that we have already had 44 deficits in the 52 years since 1930, that future budget deficits have been chronically underestimated, and that President Reagan himself, at the beginning of his term, projected a balanced budget for the fiscal year 1984, the outlook at the moment of writing this is frightening.

Now I have several things to say about this, the foremost being that every time I write or say something about the future of the economy I am well aware that it might be just as far off as Mr. Hazlitt’s remarks. There are just so many potential influences on an economy that it is very difficult to get a prediction correct. This is especially true when predicting gloom and doom in the American economy. Americans do not want to experience declining standards of living. They’ve seen it and want no more of it. So, in spite of what the government might do, Americans will work very hard to avoid really severe consequences.

Another comment that can be made is that Mr. Hazlitt did not and probably could not anticipate the understanding and competence of Fed Chairman Volker or the advisors supporting Reagan. Volker did not want a return to the inflation of the 70’s, and he led the Fed away from the actions that would “monetize” the federal debt. Reagan put money back into the hands of actually productive people by reducing taxes. So, in spite of the apparent level of deficits, the economy had room to grow. Of course, we have neither of these benefits in today’s government.

But probably, most of all for me to point out is the lesson for the reader. Economic predictions by those who oppose the government are often presented as definite, precise conclusions. People offering products or who have prominently presented a prediction will argue that their expectations will come true regardless of other, unforeseen events or influences. It doesn’t mean that their reasoning is wrong so much as that they do not realize the limitations of predictions in an economy as complex as ours.

The worth of my last set of comments can be seen in today’s financial crisis. Many, reasonably drawing on the insanity of U.S. government actions, have predicted the continued drop in the dollar. It isn’t happening. Why? Because of higher levels of insanity in other governments, plus a crisis in minor countries attracts as much attention as any other crisis. How long will the idiots in other countries keep acting in such a way that people don’t notice how poor an asset the U.S. dollar is? Who knows? There are literally dozens of other countries with their own set of idiots and insane economic programs. In comparison, the dollar might be a better option. How long will this situation favoring the dollar continue? Again, who knows?

What is a person who wants to protect themselves from the very bad policies of the U.S. government going to do? After all, the current situation is one of high risk. The dire predictions that I have been referring to and my own comments in this blog are all grounded in well thought out economics and accurate information. This is why caution, diversification, vigilance, reading, and just paying attention are all important. Patience, too. Be prepared for bad news, and do not react, by which I mean, do not be one of those who makes big changes on bad news (and be selective on the good news you react to).

In a wider perspective, Mr. Hazlitt’s comments suggests that there are some epistemological issues to consider about economics. Some contend, for example, that Ludwig von Mises is really, at root a rationalist. His presentation is seemingly deductive. I understand the source of that accusation, but in reading, for example, his Theory of Money and Credit I see significant references to events that support his position or counter the claims of another economist. He seems to me to be very grounded in real events. But, at the same time, economics is not a science that allows the type of isolation of causal factors that a physical science does. Even in the analysis of past events, in which all the information may be available, separating out the events and identifying the causal factors is far from easy and often open to ambiguity. The question of which analysis you accept ultimately falls to your understanding of the process of production and of human action (to coin a phrase). It is exactly like history. What factor in human action do you identify as primary: human intelligence, individual genius, geology, or philosophy? If your understanding of mankind is correct, your understanding of history, and also economics will tend to be correct also. Exactly how that works out in a specific situation, however, may be very complex, and the uncertainties in predicting what will happen before the event sufficient to throw off apparently well-reasoned expectations.

The lesson: figure it out as best you can, and hedge your bets. Don’t tie your actions to specific expected events but to the general trends, and don’t be surprised when actual events go against you. The point to remember is that when living within a generally irrational culture, the irrational will happen.

1 comment:

  1. and along these lines, one of the few valid things Keynes ever said:
    "The market can stay irrational longer than you can stay solvent"